Why liquidity matters in ETF cost minimization

Management expense ratios are not the end of the story when it comes to the cost of an ETF or ETF strategy

Why liquidity matters in ETF cost minimization

ETFs are well known for having low expense ratios relative to mutual funds, which has contributed significantly to the continued inflows and acceleration in AUM in the space. But for advisors who want to minimize investment costs for their clients, that yardstick is not necessarily enough.

“ETFs with the lowest expense ratios may not always be the least expensive choice overall or measure an ETF's total cost of ownership,” reported InvestmentNews.

One often-overlooked factor, according to the report, is how the liquidity of an ETF affects its trading costs. As a general rule, the most-liquid ETFs — those that see large buying and selling activity among market participants — are typically the least costly to trade.

Differences in the liquidity of ETFs become most apparent when markets are in the throes of buying or selling fever; in such times, liquidity can be rare and costly, as reflected in the bid-ask spread. Investors who rely on a high-trading strategy, particularly if they believe they can take advantage of market volatility, must keep this in mind.

Read also: The battle between ETFs and mutual funds is just a matter of time

Liquidity also takes on particular significance for ETFs that hold a place in core portfolios. Even if they’re meant to be held for an extended period as part of a long-term strategy, the act of portfolio rebalancing introduces a need to buy or sell periodically to maintain a certain asset allocation. With that in mind, buying the ETFs with the lowest MERs can still lead to significantly higher overall costs in the long term.

The liquidity of the ETF’s underlying holdings is also a factor. Those familiar with the process of ETF creation and redemption would recall that it involves considerable trading in the ETF’s component securities. If an ETF consists of less actively traded stocks, the spreads on those securities can get quite wide, leading to higher total costs of ownership.

“The cost of liquidity, therefore, whether in the secondary market for the ETF itself or in markets for the securities that comprise the ETF, is an important factor for advisors to consider when selecting an ETF and ETF strategy,” the article said, noting that it can add several basis points — possibly even exceeding the ETF’s expense ratio — to the total cost of ownership.


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